Educate yourself about Forex risk and trading, to help you reduce your risk regardless of whether you are a new trader or a professional. The reason many Forex traders lose money is not simply due to inexperience or a lack of knowledge of the market, but because of poor risk management. Proper risk management is an absolute necessity to becoming a successful trader.
You should be fully aware that several risks come with Forex trading and trading with other instruments! For this reason, the topic of managing your risk when trading Forex is very important.
UNDERSTANDING TRADING RISK MANAGEMENT
The Forex market is one of the biggest financial markets on the planet, with transactions totalling more than 5.1 trillion USD every day! With all this money involved, banks, financial establishments and individual traders have the potential to make both huge profits and equally huge losses.
While banks lending money to borrowers must practice credit risk management, to ensure they make a return on their investment, traders must do the same with their investments.
Forex trading risk is simply the potential risk of loss that may occur when trading. It's important to point out that the rules for risk management in Forex that we provide below are not exclusive to Forex trading. Whether you are interested in risk management with energy trading, futures, commodity or stock trading, the basics of risk management are very similar when trading with each instrument.
1. Market Risk
This is the risk that the market will perform differently to how you expect and is the most common risk in trading.
For example, if you believe the US dollar is going to increase against the Euro and you, therefore, decide to buy the EURUSD currency pair, only for it to fall, you will lose money.
2. Leverage Risk
Many traders use leverage to open trades that are much larger than the size of the deposit in their trading account. In some cases, this can lead to losing more money than was initially deposited in the account.
3. Interest Rate Risk
An economy's interest rate can have an impact on the value of that economy's currency, which means traders can be at risk of unexpected interest rate changes.
4. Liquidity Risk
Some currencies and trading instruments are more liquid than others. If a currency pair has high liquidity, this means that there is more supply and demand for them and, therefore, trades can be executed very quickly.
For currencies where there is less demand, there might be a delay between you opening or closing a trade in your trading platform and that trade actually being executed. This could mean that the trade is not executed at the expected price, and you make a smaller profit, or even a loss, as a result.
5. Risk of Ruin
This is the risk of you running out of capital to execute trades. Just imagine that you have a long-term strategy for how you think a security's value will change, but it moves in the opposite direction.
You need enough capital on your account to withstand that move until the security moves in the direction you want. If you don't have enough capital, your trade could be closed out automatically and you lose everything you've invested in that trade, even if the security later moves in the direction you expected.
KEY FOREX RISK MANAGEMENT
The following will help you reduce your risk regardless of whether you are a new trader or a professional:
If you are new to trading, you will need to educate yourself as much as possible. In fact, no matter how experienced you are with the Forex market, there is always a new lesson to be learned! Keep reading and educating yourself on everything Forex related.
2. Use a Stop Loss
Perhaps you've asked yourself, "Do day traders lose money?" Sure. They lose money regularly. The goal, however, is to ensure that your profits are greater than your losses at the end of your trading session. One way to protect yourself against great losses is with a stop loss.
A stop loss is a tool that allows you to protect your trades from unexpected market movements by letting you set a predefined price at which your trade will automatically close. Therefore, if you enter a position in the market in the hope the asset will increase in value, and it actually decreases, when the asset hits your stop loss price, the trade will close to prevent further losses.
It is important to note, however, that stop losses are not a guarantee. There are occasions when the market behaves erratically and presents price gaps. If this happens, the stop loss will not be executed at the predetermined level but will be activated the next time the price reaches this level. This phenomenon is called slippage.
A good rule of thumb is to set your stop loss at a level that means you will lose no more than 2% of your trading balance for any given trade.
Once you have set your stop loss, you should never increase the loss margin. There's no point in having a safety net in place if you aren't going to use it properly.
There are different types of stops in Forex. How you place your stop loss will depend on your personality and experience. Common types of stops include:
- Equity stop
- Volatility stop
- Chart stop (technical analysis)
- Margin stop
If you find you are always losing with a stop-loss, analyse your stops and see how many of them were actually useful. It might simply be time to adjust your levels to get better trading results.
Additionally, a protective stop (Trailing Stop Loss) can help you lock in profits before the market turns. For example, once you have opened a position and have a floating profit of $500, you can move your stop loss closer to the current price, so that if it was hit, your trade would close with some of your profit still intact. If the trade keeps going your way, you can continue trailing the stop after the price. One automated way to do this is with trailing stops.
3. Use a Take Profit to Secure Your Profits
A take profit is a very similar tool to a stop loss, however, as the name suggests, it has the opposite purpose. Whilst a stop loss is designed to automatically close trades to prevent further losses, a take profit is designed to automatically close trades once they hit a certain profit level.
By having clear expectations for each trade, not only can you set a profit target, and, therefore, a take profit, but you can also decide what an appropriate level of risk is for the trade. Most traders would aim for at least a 2:1 reward-to-risk ratio, where the expected reward is twice the risk they are willing to take on a trade.
Therefore, if you set your take profit at 40 pips above your entry price, your stop loss would be set 20 pips below the entry price (i.e. half the distance).
In short, think about what levels you are aiming for on the upside, and what level of loss is sensible to withstand on the downside. Doing so will help you to maintain your discipline in the heat of the trade. It will also encourage you to think in terms of risk versus reward.
4. Do Not Risk More Than You Can Afford to Lose
One of the fundamental rules of risk management in Forex trading is that you should never risk more than you can afford to lose. Despite its fundamentality, making the mistake of breaking this rule is extremely common, especially among those new to Forex trading.
The FX market is highly unpredictable, so traders who put at risk more than they can actually afford, make themselves very vulnerable.
If a small sequence of losses would be enough to eradicate most of your trading capital, it suggests that each trade is taking on too much risk.
The process of covering lost Forex capital is difficult, as you have to make back a greater percentage of your trading account to cover what you lost. Imagine having a trading account of $5,000, and you lose $1,000. The percentage loss is 20%. To cover that loss, however, you need to get a profit of 25% from the remaining capital in your account ($4,000).
This is why you should calculate the risk involved in Forex trading before you start trading. If the chances of profit are lower in comparison to the profit to gain, stop trading. You may want to use a Forex trading calculator to assist with your risk management.
A tried and tested rule is to not risk more than 2% of your account balance per trade. Additionally, many traders adjust their position size to reflect the volatility of the pair they are trading. A more volatile currency demands a smaller position compared to a less volatile pair.
At some point, you may suffer a bad loss or burn through a substantial portion of your trading capital. There is a temptation after a big loss to try and get your investment back with the next trade. However, increasing your risk when your account balance is already low is the worst time to do it.
Instead, consider reducing your trading size in a losing streak, or taking a break until you can identify a high-probability trade. Always stay on an even keel, both emotionally and in terms of your position sizes.
5. Limit Your Use of Leverage
Following on from the previous section, our next tip is limiting your use of leverage. Leverage offers you the opportunity to magnify your profits made from your trading account, but it can similarly magnify your losses, increasing the risk potential. For example, an account with leverage of 1:30 means that on an account with $1,000, you can place a trade worth up to $30,000. 55This means that if the market moves in your favour, you would experience the full benefit of that $30,000 trade, even though you only invested $1,000. However, the opposite is true if the market moves against you.
Your level of exposure to Forex risk is therefore higher with a higher leverage. If you are a beginner, a sensible approach with regards to forex risk management, is to limit your exposure by not using high leverage. Consider only using leverage when you have a clear understanding of the potential losses. If you do, you will not suffer major losses to your portfolio - and you can avoid being on the wrong side of the market.
Most brokers offer different leverages according to trader status. Traders come under two categories: retail traders and professional traders. Leverage of 1:30 for retail traders and leverage of 1:500 for professional traders. There are benefits and trade offs to both, and you can find out what is available to you by reading our retail and professional terms.
Forex risk management is not hard to understand. The tricky part is having enough self-discipline to abide by these risk management rules when the market moves against a position.
6. Have Realistic Profit Expectations
One of the reasons new traders take unnecessary risk is because their expectations are not realistic. They may think that aggressive trading will help them earn a return on their investment more quickly. However, the best traders make steady returns. Setting realistic goals and maintaining a conservative approach is the right way to start trading.
Being realistic goes hand in hand with admitting when you are wrong. It is essential to exit a position quickly when it becomes clear that you have made a bad trade. It is a natural human reaction to attempt to turn a bad situation into a good one, however, with Forex trading, it is a mistake.
With this mindset, you can prevent greed from coming into the equation, which can lead you into making poor trading decisions. Trading is not about opening a winning trade every minute or so, it is about opening the right trades at the right time, and closing such trades prematurely if the situation requires it.
7. Have a Forex Trading Plan
One of the big mistakes new Forex traders make is signing into a trading platform and then making a trade based on nothing but instinct, or maybe something that they heard in the news that day. Whilst this may lead to a few lucky trades, that is all they are - luck.
To properly manage your Forex risk, you need a trading plan that outlines at least the following:
- When you will open a trade
- When you will close it
- Your minimum reward-to-risk ratio
- The percentage of your account you are willing to risk per trade.
Once you have devised your Forex trading plan, stick to it in all situations. A trading plan will help you keep your emotions under control whilst trading and will also prevent you from over trading. With a plan, your entry and exit strategies are clearly defined and you will know when to take your gains or cut your losses without becoming fearful or feeling greedy. This approach will bring discipline int your trading, which is essential for good risk management.
It stands to reason that the success or failure of any trading system will be determined by its performance in the long term. So be wary of apportioning too much importance to the success or failure of your current trade. Do not break, or even bend, the rules of your system to try and make your current trade work.
8. Managing Forex Risk: Prepare For the Worst
No one can predict the Forex market, but we do have plenty of evidence from the past of how the markets react in certain situations. What has happened before may not be repeated, but it does show what is possible. Therefore, it is important to look at the history of the currency pair you are trading. Think about what action you would need to take to protect yourself if a bad scenario were to happen again.
Do not underestimate the chances of unexpected price movements occurring. You should have a plan for such a scenario, because they do happen.
9. Risk Management Trading: Control Your Emotions
There are many common principles in trading psychology and risk management. Forex traders need to be able to control their emotions. If you cannot control your emotions whilst trading, you will not be able to reach a position where you can achieve the profits you want from trading.
Emotional traders struggle to stick to trading rules and strategies. Overly stubborn traders may not exit losing trades quickly enough, because they expect the market to turn in their favour.
When a trader realises their mistake, they need to leave the market, taking the smallest loss possible. Waiting too long may cause the trader to end up losing substantial capital. Once out, traders need to be patient and re-enter the market when a genuine opportunity presents itself.
Traders who are emotional following a loss also might make larger trades trying to recoup their losses, but consequently, increase their risk. The opposite can happen when a trader has a winning streak - they might get cocky and stop following proper Forex risk management rules.
Ultimately, do not become stressed in the trading process. The best Forex risk management strategies rely on traders avoiding stress.
10. Diversify Your Forex Portfolio
A classic, tried and tested risk management rule is to not put all your eggs in one basket, so to speak, and Forex is no exception. By having a diverse range of investments, you protect yourself in case one market drops, the drop will hopefully be compensated for by other markets that are perhaps experiencing stronger performance.
With this in mind, you can manage your Forex risk by ensuring that Forex is a portion of your portfolio, but not all of it. Another way you can expand is to exchange more than one currency pair
Many retail traders turn to the forex market in search of fast profits. Statistics show that most aspiring forex traders fail, and some even lose large amounts of money. Leverage is a double-edged sword, as it can lead to outsized profits but also substantial losses. Counterparty risks, platform malfunctions, and sudden bursts of volatility also pose challenges to would-be forex traders.
Unlike stocks and futures that trade on exchanges, forex pairs trade in the over-the-counter market with no central clearing firm.
THE SNB EXAMPLE
To better understand the danger of forex trading, consider a relatively recent example. On Jan. 15, 2015, the Swiss National Bank abandoned the Swiss franc's cap of 1.20 against the euro that it had in place for three years. As a result, the Swiss franc soared as much as 41% against the euro on that day.
The surprise move from Switzerland's central bank inflicted losses running into the hundreds of millions of dollars on millions of participants in forex trading, from small retail investors to large banks. Losses in retail trading accounts wiped out the capital of at least three brokerages, rendering them insolvent, and took FXCM, then the largest retail forex brokerage in the United States, to the verge of bankruptcy.
Unexpected one-time events (such the SNB 1.20 Floor remaval) are not the only risk facing forex traders. There are other reasons why the odds are stacked against the retail trader who wants to get rich trading the forex market.
Although currencies can be volatile, violent gyrations like that of the aforementioned Swiss franc are not that common. For example, a substantial move that takes the euro from 1.20 to 1.10 versus the U.S. dollar over a week is still a change of less than 10%.
Stocks, on the other hand, can easily trade up or down 20% or more in a single day. But the allure of forex trading lies in the huge leverage provided by forex brokerages, which can magnify gains (and losses).